By Craig Karmin (WSJ)

A growing number of big investors are concluding that stock and bond pickers failed to add any value during the market turmoil and are shifting to index funds, a move that threatens to cut profits for asset managers.

“Active managers have not given us the added performance in a down market that we hoped for,” says Bill Atwood, executive director of the $9 billion Illinois State Board of Investment. Disappointing returns by some large- and small-stock managers led his fund to move about $400 million to index funds.

“Now that we think we’re close to the bottom, we feel we can access the upside just as well with index managers,” Mr. Atwood says.

The move toward more-passive investments is part of a broader reconsideration by many investors about what went wrong in 2008 and how they can reposition their portfolios to avoid a rerun of that dismal performance. Active managers promise to beat, rather than match, the market’s overall returns and charge fees that can be at least 10 times higher than those of index funds.

In a recent survey by Greenwich Associates, a Greenwich, Conn., consulting firm, about one in five institutional investors said they have recently shifted money away from active managers and into passive index strategies. That is up from just 4% who expected to make that shift when asked from July to October 2008.

The active-versus-passive debate is shaping up as a driving force behind industry consolidation. When BlackRock Inc. agreed this month to acquire Barclays PLC’s Barclays Global Investors, the giant index and exchange-traded-fund business, BlackRock CEO Laurence Fink cited investor efforts to cut costs through passive strategies as an impetus for the deal.

“For big money-management houses that underperformed, this trend is bad news,” says Mark Keleher, chief executive of Mellon Transition Management, which helps investors switch managers.

Thanks in large part to a growing preference for index funds, the Bank of New York Mellon Corp. unit is forecasting a record number of asset managers will be replaced in the second half of this year.

Mr. Keleher says the moves primarily involve switching from traditional “long-only” active asset managers who invest in stocks and bonds but generally don’t hedge or use derivatives, rather than from hedge funds or private-equity firms.

A change of heart in the $2.3 trillion public pension industry could quickly slice profits for the large asset managers that serve them. Stock index funds may charge annual fees of less than 0.1% of the money they manage, rarely topping 0.5%; stock pickers charge fees that can range from roughly 0.3% up to 2% of assets. Fees for bond managers are generally lower.

Greenwich Associates says that not all of the switches to index funds will be permanent and that some investors will stash their money in index funds until they find new managers.

That is partly true for the Fire & Police Pension Association of Colorado, a $2.5 billion pension fund. Chief Investment Officer Scott Simon says he is winding down a derivative-related program, known as portable alpha, and holding those assets for the time being in stock-index funds. The Colorado fund has about 60% of its stock holdings in index funds, up from 40% in 2008.

While that figure may come down, he says he intends to maintain a greater index bias going forward. “I see passive being a bigger piece of the portfolio than it has been in past,” he says. “More managers seem unable to beat their index.”

Mellon has found that some pension investors are doing the same thing with their debt holdings. Historically, the difference in performance between the top quartile and bottom quartile of bond funds was about half a percentage point, Mr. Keleher says.

Last year, that gap widened to about six percentage points. Rather than try to pick winners, many institutional investors are more worried about being stuck with losers, so they now are choosing index funds.